Middle East Investors Having Trouble Finding Value

With all that is happening in the world – the U.S. election, the Brexit vote, various terrorist incidents, speculation about will she or won’t she raise rates at the Fed and other concerns – oil seems to have been pushed down the priority scale of market-influencing issues. The price of West Texas Intermediate has varied between the low and high $40s for months as investors have reacted to news about restrictive fracking legislation, Saudi Arabian production, demand in a slowing world economy and the liquidation of the huge crude inventory overhang. Given that oil has certainly not diminished as the world’s most critical commodity, I thought I would like to learn more about what is going on in the Middle East. So at the end of last month, I traveled to Abu Dhabi, Saudi Arabia, Qatar and Dubai to meet with Blackstone’s limited partners and others and probe into their thinking about energy and the geopolitical environment in the region.

Like investors everywhere, asset allocators in the Middle East are having a difficult time finding attractive opportunities for capital appreciation. They are apprehensive because the current business expansion, one of the longest on record, has continued for 87 months. On monetary policy, which they considered important, they are confused because they hear that the U.S. economy isn’t growing fast enough for the Fed to raise short-term interest rates (which they view as a positive), but are also hearing that rates have stayed too low for too long and raising them would put more money in retirees’ pockets and actually help the economy grow. They are worried that the spread of populism across Europe will cause a breakdown of the European Union and fear that the decision to leave by the United Kingdom is only the beginning. The anti-trade and anti-immigration policies of populism would not be good for Middle East business people or their investments.

I had an opportunity to address a Brexit concern in mid-September. United Nations Week was taking place in New York and, as expected, the traffic was materially worse than usual. I was invited to a reception for the new U.K. Prime Minister, Theresa May, and I debated about going because I knew it would be impossible to get there and I doubted that I would learn much, but I decided to brave it anyway. After a brief speech, she took a question from each of the people who lined up to engage her. I asked her whether the European countries were going to treat Britain like an “escaped prisoner” (Henry Kissinger’s phrase) and punish it for voting to leave or whether they would negotiate bi-lateral trade deals with a positive attitude. She answered, “Europe views me as a victim. I supported the ‘Remain’ vote. The populists took over the mind of the electorate and defeated us. Many European leaders feel like they are victims of populism also and sympathize with me. I think European leaders will have a constructive attitude toward trade negotiations with the U.K.” If she turns out to be right, U.K. and European stocks are a buy.

Middle Eastern investors are apprehensive about the U.S. presidential election. While most believe a victory by Donald Trump would bring increased uncertainty to the world economic outlook, some believe lower taxes might stimulate growth. The one issue that doesn’t bother them is terrorism. To be sure, a major building was blown up in Dubai on New Year’s Day, although whether terrorists were responsible is unclear. I visited only Sunni countries and their fear is Iran. They believe Iran is proceeding with its nuclear program in spite of the agreement signed in 2015 to cease weapons development. One thing that Israel and most Middle East countries agree with Donald Trump on is that the Iran deal was a bad decision. Last week at the Council on Foreign Relations in New York, Vice President Joe Biden defended it vigorously. While Iran is a major source of apprehension in the region, it is also a place where there is hope for the future. While the religious leaders maintain tight control, the restless growing young population wants the freedom and economic opportunity they see in the West. As a result, there is some optimism that the friction between Shiite Iran and Sunni countries will diminish, but admittedly this change is likely to occur over a long period of time.

At least Middle East countries are planning for the day when oil will cease to be the driver of their economies that it is today. They recognize that the United States is striving for energy self-sufficiency and other economies are trying to become less dependent on fossil fuels. As a result, the oil-producing countries will focus more on returns on their investments for their economic health. Oil has made them thriving urban financial power houses with luxury hotels and dazzling infrastructures. Abu Dhabi will have an outpost of the Louvre (well underway) and a Frank Gehry Guggenheim to enrich its cultural life. To sustain a positive future, however, Middle Easterners will need a reasonable return on their enormous accumulated assets. They worry that conventional investments in public securities will only give them a mid-single-digit total return. They are looking more toward distressed situations and “alternative” investments to provide the double-digit returns they enjoyed in the past.

While you would think that talking to asset allocators and officials in the Middle East would give you a special insight into the future direction of oil prices, the opposite seems to be true. Most believe the price of oil is determined more by the growth of the world economy than any other single factor, and someone following the flow of the news in New York or London is in a better position to gage that than they are. They also think there are so many variables involved that forecasting the future price is difficult if not impossible. They wonder if regulation will slow the development of hydraulic fracking in the United States, whether the large inventory of oil now in storage will flow into the market, holding down prices, whether Brexit will slow European demand, whether China’s slowdown will have a material effect on its energy imports and whether the 75% decline in the rig count and a corresponding cut in energy capital spending will limit increases in future production. As a result, they believe the price will remain in the current range of $40 to $50 a barrel for a while even though many Western observers see higher prices in the intermediate term. When I told them that many are forecasting $70 a barrel before 2020 for Brent and West Texas Intermediate, they agreed it was possible, but they were not counting on it. Since many of the Middle East oil-producing countries are running current budget deficits, they would have to reduce government services if prices did not improve.

On the day I returned from the Middle East, OPEC announced a tentative agreement to cut production by 700,000 barrels a day, which would be the first reduction in output since 2009. Prior to that, West Texas Intermediate appeared to be heading back into the $30s, and they obviously didn’t want that to happen. The price of oil immediately moved up by 5% to the high $40s. Whether all OPEC members will agree to cut production remains unclear, and the oil markets reflected that uncertainty on the day after the announcement.

There was great interest in my views about what was happening in China, which is a major market for oil from the Middle East. Observers in the region are no longer worried about a “hard landing.” The concern now was the increase in military expenditures and the establishment of bases in the South China Sea. I told them that I believe China continues to be focused on economic growth and the creation of ten million or more urban jobs for its population. China believes that its status as the second largest economy in the world has earned it a place of importance in determining policies affecting international affairs, but despite the military expansion, hostilities with Western powers are not on its current agenda. Middle Eastern business people were also worried about North Korea having a nuclear device because the leadership there is totally unpredictable.

The dominant theme in every conversation was the difficulty of finding investments that provided a reasonable return. The general assessment was that public equities were fully priced; the investment grade bond market was overpriced with low yields inadequately compensating investors for the risks they were taking; commercial real estate was also expensive; a surplus of capital in private equity funds was making the competition for attractive deals intense; commodities had been depressed but they had recovered somewhat over the past year; and hedge fund fees were too high with disappointing performance. Consequently, some of the investment managers I talked with were both investing in private equity deals directly (rather than through funds) and making loans to entrepreneurs that were providing high-single-digit returns.

Most Middle Eastern countries are looking to diversify their economies beyond oil. They see opportunities in tourism, expanding their middle class, downstream uses of energy like aluminum production and chemicals, and taking advantage of their strong balance sheets. They are disturbed by what they see happening around the world. They feel the United States is becoming inward-looking. They worry about the long-term objectives of Russia and see its growing closeness with Turkey and its involvement in Syria as part of a plan to become a dominant participant in world affairs. Although Russia’s poor economy is a limitation on these objectives, Vladimir Putin appears willing to put his population through any amount of pain to achieve his goals. Middle Easterners see weak leadership in Egypt as a potential problem for the region. They believe that the democratic government in Kuwait is too slow to make important decisions and that this is a problem in the region.

In some of the sessions we discussed the productivity issue. The investors I spoke with believe this is a worldwide problem. They agree with many market observers worldwide that mechanical (robotics) and information technology has made productivity harder to measure. Given that productivity is critical to improving living standards and corporate profitability, it is important to make every effort to increase this component going forward. One impediment to higher productivity is that the world is moving away from goods production and toward providing services, and productivity improvements may be harder to achieve in the service sector.

The Middle East seemed to be thriving in spite of the decline in the price of oil. In every city I visited, plenty of cranes signal the construction of new buildings and the mood is upbeat. There is a sense that the middle class is growing in the region as it is in India and China, and where that is happening there is opportunity. It is just harder to find then it was in the past.

The first Presidential debate occurred while I was on the trip. I was surprised at how many people I met with watched at least a part of it since it took place at three or four in the morning depending on where you were in the region. Most agreed that Hillary Clinton seemed well prepared and in control. They thought that Donald Trump did not introduce any new ideas into the discussion and that his responses on bringing jobs back and not paying taxes were weak. If Clinton was the winner, as the pundits say, then why didn’t her poll numbers improve more than two to three points? The reason may be that Trump supporters are “true believers” in his policies for radical change. While Clinton gained some points in the polls, the November outcome is still too close to call. Two days before the Brexit vote, the Remain camp was two to three points ahead, but that turned out to be insufficient to win. There may be a parallel here. It looks like the election will be a cliffhanger until the very end. There is a large number of people everywhere, especially in the United States, who are dissatisfied with where the country is heading and they want change. The power of populism is a strong force throughout the world.

At the end of September, Congress overrode a veto by President Obama and passed a bill allowing families who lost relatives in the 9/11 attacks to sue Saudi Arabia for their possible involvement in those attacks. Many Democrats voted with Republicans in spite of the objections of the President. Accordingly, U.S. relations with Saudi Arabia, already strained because of the Iran deal and other factors, are likely to be under further pressure.

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